Recent market commentary has obsessed over how much further the stock market could fall in the short run, and the interminable question of when the US Federal Reserve might begin to raise interest rates.
It is hard to find a sensible answer to the first question. The second has been so exhaustively canvassed as to make any further analysis mentally painful.
There are two better questions to ask right now. The first concerns the outlook for the U.S. economy in the wake of a few weeks of positive economic numbers and negative markets. The second is what assets appear to be the best bargains following a general global sell-off in risk assets.
Performance of indices during the sell-off
Source: FE Analytics
On the first, an update to our internal models shows a promising medium-term outlook for the US economy. Real GDP growth was revised up to 3.7 per cent in the second quarter from an earlier reported 2.3 per cent.
More importantly, however, the major areas of demand in the economy look quite healthy in the middle of the third quarter.
Real consumer spending, in particular, has risen by 3.1 per cent over the past year and has significant momentum. US consumers are benefitting from lower gasoline prices, a solid improvement in home prices, better job growth and some increase in wages.
This steady pace of real GDP growth, in a world of lower productivity growth and anemic labor force gains, has already reduced the unemployment rate to 5.1 per cent, well below its 50-year average of 6.2 per cent, and should cut it further to 5 per cent by the fourth quarter of this year and close to 4 per cent by the end of next.
Assuming no significant shocks to the economy or global financial markets, we still narrowly expect the Fed to begin raising rates short-term interest rates this month, skip a meeting in October and raise rates again in December.
This should be followed by four rate hikes in 2016, in line with the current ‘dot plot’. In this environment, we expect long-term interest rates to rise also with 10-year Treasury yields averaging 2.50 per cent in the fourth quarter of this year and 3.30 per cent in the fourth quarter of 2016.
A gradually growing economy combined by an edging down in the exchange rate and an edging up in oil prices should set up a profit revival, with S&P 500 operating earnings falling by about 3.0 per cent in 2015 but then jumping by more than 10 per cent in 2016.
Turning to financial markets, August was clearly an ugly month and September has not started out much better.
However, it should be emphasized that, with the S&P 500 at a level of 1921 as of last Friday, the index is priced at 15 times forward earnings, which is below the 15.7 average of the last 25 years. In fact, a number of valuation measures now show the U.S. stock market to be cheaper than average in absolute terms and much cheaper than average relative to very low interest rates and inflation.
In U.S. equities, if our economic forecast is correct long-term interest rates should rise and corporate profits should rebound in 2016. With this prospect, financials, technology and consumer discretionary stocks all appear well positioned with high betas to the overall market and a positive correlation to rising interest rates. Energy stocks still look expensive and utilities look vulnerable to rate hikes.
In global equities, emerging market stocks have understandably underperformed in 2015, with the MSCI Emerging Markets index down 12.6 per cent by the end of August, compared to a flat performance from the MSCI-EAFE.
Performance of indices in 2015
Source: FE Analytics
Chinese weakness is continuing to negatively impact manufacturers in East Asia and commodity producers around the world. However, it is worth noting that, at an overall price-to-book ratio of 1.3, emerging market stocks are now at valuations that have proven to be good entry points in the past.
European stocks seem even more compelling in the short run as a falling unemployment rate and low commodity prices should spur consumer spending while a low Euro boosts Europe’s share of global export markets.
By contrast, fixed income markets seem ill-prepared for a Fed lift-off.
Futures markets are generally not pricing in a September rate hike. The 10-year Treasury yield was just 2.2 per cent at the end of August, or roughly 40 basis points above year-over-year core inflation. This compares to real yields of roughly 2.5 per cent over the past 50 years.
High yield bonds in both the United States and Europe look a bit more attractive as do some emerging market US dollar-denominated bonds.
However, if our U.S. economic forecast is right and the Fed does begin tightening into an improving economy, the outlook for global fixed income is generally challenging and investors will want to keep durations relatively short.
Investors may use this week to contemplate market volatility and Fed tea-leaves, but the better questions to ask are about economic momentum and market valuations. Our answers to those questions still point to a modest overweight to global equities.
David Kelly, chief global strategist at J.P Morgan Asset Management. All the views expressed above are his own.